3 ways investors often misjudge risk.
By Thomas Lyck.
About the author: Thomas Lyck is CEO at Formula Stocks. He’s been investing for 27 years. https://formulastocks.com provides a scientific approach to beating the stock market.
1. Risk and reward go hand in hand.
Risk and reward can, at times, be equal, or symmetrical. Most of the time, though, the relationship between risk and reward is more or less asymmetrical in either direction. As an investor, you will want this relationship to be strongly asymmetrical. Specifically, you will always want to be invested in assets where reward outweighs risk, and never be near a situation where risk outweighs reward. In classic value investing, this is achieved by insisting on a margin of safety. By starting out with a rebate, you already know that there is more upside than downside. In other investment disciplines, an asymmetrical relationship can (should) also be ascertained before investing.
2. Volatility equals risk.
This is a long-standing misconception amongst investors. Volatility is as much opportunity as it is risk. Consider an asset with zero volatility. It flat-lines. It would never be able to earn you a single cent. And as we know that the monetary unit of choice, the dollar, is constantly losing value, not earning a single cent means in fact losing money, slowly, but constantly. From this we can deduce that zero volatility includes some risk.
Consider an investor who earns a return on his assets that is well above average, which, then, by definition, are also highly volatile. Would he consider his strong earnings a risk? No. So higher volatility cannot be termed maximum risk either. Let us instead consider higher volatility either opportunity or risk, and no volatility as no opportunity and little risk.
Risk is more properly thought of in terms of differences between the price of an asset and a theoretically correct intrinsic value. In terms of measuring “risk”, measures like the Sharpe Ratio, are more or less meaningless. It penalizes outperformance, which is not risk. The Sortino Ratio is better (it focuses on downside volatility). However, for a proper, nuanced, and balanced view you should chose the Omega Ratio, which properly displays risk versus reward as a function rather than as an oversimplified one-dimensional number, which at best reveals less than half of the equation.
Stocks are dangerous, and cash is safe.
Let us examine this idea in detail. Cash is safe? Seeing as the dollar has lost 96% of its purchasing power since 1913 based on CPI statistics, it is safe to conclude that holding cash is a sure fire way to financial ruin. Of course, it is a predictable and relatively slow destructor of value. It is said that if you put a frog in a pot of water and gradually turn the heat up, the frog does not react and thus fails to jump out of the pot before it is too late. Holders of cash fare much like the frog in the example, unaware of their slow, but certain future demise.
Alas, there is no such thing as absolute safety. There is always risk, and it may be so well-hidden that you just do not see it. An attempt to avoid risk altogether may backfire, as it is not possible in extremis. It is better to understand risk, embrace it to the extent it is tolerable, and provided that the reward associated with it, outweighs the risk. On a more subjective note, the highest level of relative safety is found in assets which are priced below an objective long-term intrinsic value, yielding a relative margin of safety. Such a rebate, should you be able to obtain it, is as close to relatively safety as it is possible to come.
In 2017 you can still find some stocks priced below their intrinsic value in an otherwise quite expensive market — selected gold mines, for instance, but also other assets. Stocks are generally expensive, and a correction may manifest itself. But it would be wrong to consider stocks as an asset class dangerous, and cash safe. The intrinsic value of a paper dollar is 0. This is its ultimate value, which will become evident in time. The intrinsic value of a blue chip stock is typically much, much higher, and it may well grow over time. From a long-term perspective, stocks represent the much safer asset, as they give you a fighting chance not only to maintain, but also to improve your purchasing power over time. Cash is not even a competitor.
For more on how to optimize risk and reward, see https://formulastocks.com
